China’s Debt Problems

Fellow blogger Paul Hodges made a convincing case in a post on Tuesday that China’s economic model faces some major challengs.

“It seems increasingly clear that China‘s economic policy took a wrong turn 10 years ago, when it joined the World Trade Organisation,” wrote Hodges.

From 2001 onwards, China transformed itself into the manufacturing workshop of the world as it took advantage of low tariffs under WTO membership, he added.

But that year also marked the point when western Babyboomers – those born in 1946-1970 – began to leave the peak consumption age group of 25-54 years.

“As they entered the 55 plus age range, and the children left home, they began to spend less and save more,” continued Hodge.

Low interest rates artificially propped up Western demand that has peaked for several generations to come because of demographics, he argued.

China invested some $500b in US housing agencies Fannie Mae and Freddie Mac in order to keep the party going.

“This was a form of vendor finance to support the export drive. Unless the US housing market stages a recovery, which looks increasingly unlikely, write-downs are inevitable.”

The heavy export focus has halved personal consumption as a percentage of China‘s GDP to 35% in the ten years since 2001.

The Western credit binge has, of course, come to and end as populations age in the US and Europe.

When the global financial crisis struck in Q4 2008, China faced the prospect of mass unemployment and major social unrest as export orders dried-up.

The solution was the biggest lending binge in economic history for a country the size of China. Bank lending was doubled to $1.4bn, a third of GDP, and was maintained at this level in 2010.

A further $580bn of government money was spent on subsidies for consumers to buy autos and electrical goods.

Inevitably, this brought forward chemicals demand – for example, Hodges estimates that apparent demand for polyethylene (PE), which comprises imports and local production, grew by 53% in 2008-2010.

Since late last year, the government has been trying to solve the problems created by this epic stimulus package.

Bank lending is now down 29% (red square) versus the year-to-date 2009 total, as the chart at below illustrates:

Interest rates have been raised, along with numerous increases in bank-reserve requirements – the percentage of reserves that the state-owned banks have to set aside against lending.

The speculators who buoyed chemicals and polymers demand in 2009-2010 – those who were able to borrow money easily and flip between gambling on cargoes of chemicals, other commodities and real estate – are now going bust by the legion.

This is a deliberate government policy as Beijing tries to work speculation out of the economy, say several senior chemical industry sources with responsibility for China.

The objective is to reduce overall inflation and bring real-estate prices down to more-affordable levels for the vast majority of the population which, by western standards, remains very poor. Ninety six per cent of Chinese earn less than $20 a day, said Hodges.

House prices are now ten times average household incomes, double their peak during the US housing boom, he argues – thanks to all the hot money flowing into real estate during 2009-2010.

But far more seriously over the longer term, the great lending binge has created the potential for a major non-performing loans crisis.

Ratings agency Fitch is concerned that 30% of China‘s loans could turn bad.

“It means that $2.5 trillion of loans might not be paid, and yet 2010 GDP was only $5.9 trillion,” says Hodges.

“Even if we halve Fitch’s estimate, this would still mean loans worth 21% of GDP would not be repaid. This is a big haircut even by eurozone standards.”

A further problem is that the Chinese government is struggling to keep all the country’s different economic and social groups happy.

The first priority, back in late 2008, was as we said all the tens of millions of migrant workers who could have lost their jobs.

“Now the ‘sandwich generation’ is the priority,” said the Greater China vice president for sales and marketing with a global polymers producer, who is based in Hong Kong.

These are young professionals too poor to by far to afford private housing, but too rich to qualify for government-subsidised homes.

So, in addition to higher interest rates and bank-reserve requirements, a concerted effort is being made to bring-down property prices through other real-estate specific measures. These include higher mortgage deposits and experiments with a property tax.

“I will especially stress that there won’t be the slightest wavering in China‘s property-tightening measures–our target is for prices to return to reasonable levels,” China‘s Premier Wen Jiabao was quoted as saying in a speech made in Russia earlier this month.

Overall price declines of 20-30% will be tolerated by the government, believe the senior chemical industry sources with responsibility for China.

Property prices in China‘s major cities have started to decline, as sales volumes also dip and developers go bust.

But by keeping the “sandwich generation” constituency happy, what about all the average workers who bought into the property boom at the tail-end and are now in negative equity? Shanghai witnessed a demonstration by disgruntled, underwater home owners on 22 October, according to the New York Times.

And what if the downward price spiral, as downward price spirals have a habit of doing, accelerates of out control? What then of China‘s non-performing loans problem?

Perhaps, as has been the case before in China, its economic problems will eventually be tackled so we can return to double-digit annual growth for everything from PE to paraxylene (PX).

In the meantime, though, chemical and polymer companies that remain bullish on China are likely to be forced to counter the logic of the doubters – step by step, point by point. Broad-brush statements about continued urbanisation, and about the rise of the China middle classes, should no longer be sufficient to satisfy investors.